Side-letters are generally viewed by managers as a key fundraising tool by which they can bestow 'most favoured nation status' fee rebates, preferential redemption terms and a host of other benefits in return for investments. However, the latest in a series of decisions from the courts of the Cayman Islands demonstrates that in many cases side-letters do neither investors nor managers much good.
In the matter of Lancelot Investors Fund, the investment manager and an investor had agreed a shorter-than-normal lock-up period for redemptions. At first instance, the Grand Court found that the side-letter was not enforceable as neither party to the side-letter had the requisite authority on the basis that side-letters attaching rights to shares could only be enforced if entered into by the registered owner on the one hand and the fund itself – not the manager – on the other.
That decision has now been partially reversed by the Cayman Islands Court of Appeal which has ruled that in a liquidation a beneficial owner of shares can directly enforce certain rights; however, the court ruled that the investment manager in that case had neither actual nor ostensible authority to bind the fund and thus the claim, and the appeal, failed.
The investor had invested via a custodian bank – the nominee – in redeemable shares issued by Lancelot Investors Fund. The shares were subject to a lengthy lock-up period set out in the fund's confidential information memorandum (CIM). The investor sought to vary the lock-up period by entering into a side-letter directly with the investment manager of the fund.
In October 2007, the nominee submitted a redemption request for $29 million in accordance with the terms of the side-letter. The administrator confirmed the redemption of those shares not affected by the lock-up but refused to permit redemption of the locked-up shares. In other words the administrator refused to give effect to the side-letter and effected the redemption in accordance with the fund's normal rules.
The fund subsequently became the subject of an order for winding up, an official liquidator was appointed and the nominee submitted a proof of debt (POD) for the balance. The liquidator rejected the POD primarily on the basis that the redemption request was correctly refused because the amended lock-up period set out in the side-letter was ineffective in respect of the remaining shares.
The investor, rather than the nominee, appealed to the Grand Court against the rejection of the POD.
The judge at first instance held that:
1. The remaining shares still vested in the nominee and unless and until the remaining shares were transferred to the investor, the investor had no standing to appeal the rejection of the POD;
2. The side-letter was not binding on the fund: it was not executed with the fund's authority and had not been ratified by the custodian; and even if duly authorised, amounted to an invalid variation of class rights; and
3. The redemption request did not amount to a request to redeem at the first available date, and once it had failed, no longer stood effective.
The investor appealed to the Cayman Islands Court of Appeal on the following grounds:
1. That the judge was wrong to hold that the investor had no locus to appeal against rejection of the proof; instead, he should have held that the right to enforce the nominee's claim had become vested in the investor as a result of the custodianship arrangements between them, or as a result of the termination of those arrangements.
2. That the judge was wrong to hold that the side agreement was not binding on the fund.
3. That the judge was wrong to hold that the redemption request was of no effect.
The Court of Appeal concluded that it was no bar to enforcement that the investor was the signatory to the side-letter:
1. While the general rule remains that only a registered shareholder may bring proceedings to vindicate shareholder rights, once a company goes into liquidation, all provable claims against the company rank for dividend, which may be assigned pursuant to the Companies Winding Up Rules;
2. Once the nominee became a proving creditor then there was no obstacle to the investor maintaining an action as equitable assignee and so was entitled to be regarded as a creditor for the purpose of the rules; and
3. The side-letter was deemed to have been made by the investor as agent for the nominee.
However, ultimately this was not enough for the appeal to succeed as the Court of Appeal upheld the Grand Court's finding that the side-letter was not binding on the fund because:
1. Despite the CIM expressly contemplating the variation of lock-up periods, the investment manager did not have actual authority to make such an arrangement;
2. There was no evidence before the court of the investment manager having ostensible authority to do so;
3. The fact that the investment manager had "been let loose on the investors" did not in the circumstances give it ostensible authority to make representations as to the fund's decisions about share redemption; and
4. A transaction acknowledgment from the administrator could not amount to a ratification of the side-letter by the fund because the administrator was similarly not authorised to transmit the decisions of the board.
Although the Court of Appeal did make clear that "there is no doubt that in ordinary circumstances the rights attaching to shares may only be pursued by the registered shareholder" it is clear that investors will be heartened by this decision as to their rights in a liquidation of a Cayman fund. Indeed, it may be felt by some investors that the rule of company law that beneficial owners of shares shall not be recognised by the company has become overly harsh in the modern context where intermediaries are the norm.
While nominees or custodians will normally be required to deal with ordinary corporate actions they will often be reluctant to enter into side agreements or to take contentious steps on an investor's behalf, even where those steps are necessary to protect the investor's interests. The reality of the use of intermediaries has been recognised in the Cayman Islands in the context of schemes of arrangement where the Grand Court has explicitly permitted the practice of "looking through the register" for voting purposes where custodians or clearing houses are used.
There is no suggestion at present that the Cayman legislature would consider following the lead of Ireland, which has defined a "unitholder" in a Ucits fund not simply as the person entered on the register of the fund but as "any person who by reason of the holding of units in the undertaking or by reason of having invested capital in the undertaking is entitled to any of the investments or relevant income of the undertaking".
On the other hand, the Court of Appeal held that there was nothing in the fund's documents that gave the investment manager actual or ostensible authority to sign a sideletter amending the rights attaching to the remaining shares. There was no evidence that, at the time that the side-letter was entered into, the fund's directors approved the actions of the investment manager. Further, the fund directors had on occasion passed resolutions authorising the entry into side agreements, but no such resolution was passed in respect of the sideletter with the investor.
The fund industry may differ in their views of the authority that a manager has to deal with third parties on the fund's behalf; indeed, most in the industry would say that there is more to it than a manager being "let loose on investors". The fact that an investment manager of a fund will have a separate corporate identity is, in this context, not relevant. The manager acts on behalf of the fund in the same way that a general manager does at a trading company. The board delegates the management function and the manager acts accordingly.
However, it is clear that the Cayman courts will look for such authority primarily in the fund's constitutional documents or a resolution of the fund's board. In those circumstances it would be unwise for any investor to rely on a side-letter transacted with a manager without having the manager's authority checked by counsel first.
Side-letters: A checklist
1. If you are party to an existing side-letter that may fall foul of the issues outlined above – ask for ratification by the custodian/ nominee, if on the investor side, or the fund's board, if on the manager's side.
2. Prior to entering into a side-letter – check that the manager has the requisite authority in the fund's articles or other constitutional documents and/or a resolution by the board of the fund.
3. Have the side-letter checked by counsel – how does it interact with the fund's constitutional documentation? Is it, as the court in Lancelot found at first instance, an impermissible variation of class rights?Article first published in Hedge Funds Review, July 2015
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.